Q: My wife and I have a small construction business. We hired a consultant to help us with our business planning. Since we don't have a lot of cash on hand, we offered to give him some equity in our business.

What he came back with seems a little weird. He says he's willing to put $25,000 into our business to be paid back over two years. He also wants a monthly payment of 15 percent of our net profits for the next five years, to be followed by royalty payments of 5 percent of our gross sales.

Doing the math, he's likely to get over $300,000 on top of his initial investment over 5 years, which is an astronomical return. Is this legal?

A: Your consultant may be an expert on business planning, but he has a little to learn about finance.

First of all, you didn't ask him to invest in your business. Since he is providing consulting services, he should be paid a fee, which can indeed be based on your revenue or profit. Because each payment is compensation for his services, it will be taxed at an extremely high ordinary income rate, and there's a risk he will have to pay taxes on the fair market value of each payment he receives.

It's an educated guess, but I think he's offering to invest in your business because he thinks he will somehow get a better tax treatment that way. But I'm not sure he will.

Now let's take a closer look at his investment proposal.

There are only two ways to make an investment in a small business:

—You lend money to the company and take back a note with interest.

—You make an equity investment in the company and receive a percentage of future profits and losses.

He wants to get his $25,000 back over two years. That sounds a little bit like he wants to cover a debt. He didn't specify an interest rate though. Loans to a company must bear a percent interest at least equal to the lowest legal rate allowed by the IRS (called the applicable federal rate, or AFR, which is currently around 1.5 percent per annum). Otherwise, the IRS will impute interest on the loan, usually at a much higher rate.

He wants to receive a share of your profits and gross sales even after the loan is paid off. That seems a lot like an equity stake, especially since the 3 percent royalty on gross sales would continue for as long as you are in business.

It is possible to make a loan to a company in exchange for interest plus an equity kicker. Perhaps this is what the consultant has in mind. Normally, an equity kicker — a percentage of either the company's gross sales or net income — terminates when the loan is paid off. Also, in some states, the equity kicker can't exceed the maximum allowable rate of interest under the state's usury laws (usually 15 to 20 percent per annum).

Keep in mind that if the consulting fee payment is based on your net profits or net income, your consultant will almost certainly want the right to audit your books and records to make sure the payments are calculated right.

He clearly needs to talk to his financial advisor or attorney to get a better understanding of how this all works. In the meantime, assuming you really believe this person will add value to your business, I would propose the following:

You and the consultant enter into a consulting agreement where he would provide specific services in exchange for 5 percent of your monthly gross sales or $1,000 per month (whichever is greater), only for as long as the agreement is in effect.

If you wish, you can also give the consultant a warrant to acquire up to a 15 percent nonvoting interest in your company, exercisable no earlier than two years into your relationship, at your company's then-current valuation.

That way, the consultant will be required to prove his value to the company before you issue him any equity, but he will be required to pay for the equity at fair market value, which makes a lot more sense than a loan you probably don't need anyway ($25,000 is an extremely small amount of money for a construction company).

A Note on New Crowdfunding Regulations. New U.S. Securities and Exchange Commission crowdfunding regulations went into effect on May 16, 2016. These regulations allow small businesses to tap the web and their social media networks to raise capital. My new book, "The Crowdfunding Handbook" (On Amazon, search "Cliff Ennico" or "The Crowdfunding Handbook"), explains how to take advantage of this exciting new financing approach.

This week, I also posted a 1-hour video on YouTube, called "Crowdfunding Your Business: Understanding the New Rules for Raising Capital on the Web," about crowdfunding your business under the new SEC rules. View it for free on YouTube, or listen to the audio version at http://westportlibrary.org/digital/podcasts/crowdfunding-right-your-business.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.